World crude oil prices exceeded $70 per barrel through most of 2007 and reached a record high of $86.47 yesterday, 15 October 2007.
This is in sharp contrast to 2003 where the price hovered around $30 per barrel. The steep price increase is attributed to growth in demand and shortages in supply. The U.S. Department of Energy ("DOE") and the International Energy Agency ("IEA") both project rapid growth in OPEC output and market share. IEA projects much less Non-OPEC supply and world oil demand, in comparison with DOE. IEA projects Non-OPEC supply in 2020 to be lower than in 2010, while DOE projects continuing growth. However, both have Reference Case projections of OPEC share of the world oil market increasing rapidly for two decades, to about one-half of the world market by 2020. Such rapid increases in OPEC market share are highly unlikely given OPEC's (i) long term interests in maintaining its market share and (ii) its pattern of reneging on promises to increase oil production for the past four years.
OPEC has refused to increase production for a number of reasons. First, OPEC wants to avoid increasing output and market share due to the lowering of the market clearing price for crude oil per barrel. This means that OPEC receives lower revenue as it increases its market share. Second, OPEC understands that OECD demand for oil is not responsive to price increases due to high income elasticities. Therefore, they can sustain higher prices because higher income elasticities increase projections of energy and oil demand.
Third, empirical data asserts that the direct effects of oil prices on supply are asymmetric, given the sunk costs of developed oil wells: keep producing oil as long as price is above marginal extraction cost. Price's indirect effect on supply via its effect on oil reserves is also asymmetric: oil price increases stimulate exploration and development, causing an expansion of oil reserves, but oil price decreases do not lead to a decline in oil reserves. The last reason is political, that is, the loss of Iraq as an OPEC producing member. The loss of Iraq's contribution to the cartel's supply chain strains other OPEC member supplies and production rates. This makes increased production beyond 29 million MBPD unlikely given increases in cost of production and lower payoffs. Thus, we are likely to see OPEC continue to restrict supply, maintain its current market share, and tolerate OECD countries' actions to mount inventories because world oil demand is asymmetric to price increases.
Questions and Answers
1. What does this all mean?
In simplistic terms, this means that we will pay whatever price oil commands until we have a viable economic alternative solution for energy. The Yaris and Prius are not enough - the automotive industry must get off the pot and produce a wider variety of (more stylish) hybrid vehicles. Also, we must figure out how to switch heat sources for our homes and buildings as well. Either way we slice it, we have our work cut out.
2. Will Oil hit $100 per barrel?
Yes. When will it hit $100? My guess is late 2008.
3. Is $100 per barrel sustainable?
No. According to Dr. Gately, "sharply higher prices that overshoot a long-term equilibrium path could be the short term result, together with lower economic welfare worldwide." This will force us to find more economical energy substitutes through technological innovation, e.g. Green Energy. With the advent of technological developments, we will see demand for oil decrease as people switch energy sources. When will this happen effectively? My gut says no time soon - think 2020.
4. Is $86.47 per barrel sustainable?
It Depends. The current price may be sustainable if the US continues to ruin its relationships with Oil Exporting countries. For example, Congress' decision to define the Ottoman's massacre of the Armenians as genocide did not help our purposes from an economic or military standpoint with Turkey. Although Turkey should address its controversial past, telling them to do it because we said so was not appropriate. Angering Turkey will only lead to more difficulties in Iraq which will cause more US resentment by Oil Exporting countries and the rest of the World for that matter. This will translate into internal political pressures at OPEC to not increase oil supplies as per US demand for oil. (Yes - I am saying that OPEC will make decisions based on politics should the US continue in its current controversial direction.) It may also be sustainable If non-OPEC producing countries do not increase their market share.
5. What is a reasonable price per barrel?
I think $85 per barrel is reasonable to expect for the next few years given market uncertainties and oil group tendencies to choke supply. I hope that the price drops to $65 per barrel because OPEC's justification for doubling the price per barrel from $30 in 2004 due to the loss of Iraq as an OPEC member is slightly plausible.
6. What is the DOE saying?
Pay them no never mind. They have been wrong and will continue to be wrong for the foreseeable future. Instead, listen to NYU's Dr. Dermot Gately. If you do not believe me (which is fine), then please visit the following sites and compare the results for yourself.
For more details on the Dept. of Energy "International Energy Outlook" on World Oil visit here.
For more details on the International Energy Agency's outlook, visit here.
For more details on price elasticity and irreversiblility see Dermot Gately's research on energy consumption here.